More to Like Overseas as U.S. Stocks Sputter

Global Chief Investment Strategist and Head of the Model Portfolio & Solutions Business

Weekly Commentary Overview

U.S. stocks had an abysmal week, pulling back sharply from their recent highs. The major culprit for the poor performance: Revenue growth for U.S. firms remains disappointing, even as earnings are beating expectations (albeit diminished expectations).

The easing of risks overseas and improvements in the U.S. economy have more investors convinced that the Federal Reserve (Fed) will begin lifting interest rates later this year, perhaps as early as September.

Elsewhere, other developed markets are faring better. Although European equities also suffered through a tough week, they at least have the cushion of stronger earnings, partly fueled by the euro's weakness.

In Japan, equities remain resilient thanks in part to a continued re-allocation into stocks by Japanese pension funds.

All of these trends reinforce our preference for international developed markets.

U.S. Stocks' No Good, Very Bad Week

U.S. stocks had an abysmal week, pulling back sharply from their recent highs. The Dow Jones Industrial Average declined 2.86% to 17,568, the S&P 500 Index was down 2.21% to 2,079 and the tech-heavy Nasdaq Composite Index lost 2.34% to close the week at 5,088. Meanwhile, the yield on the 10-year Treasury fell from 2.34% to 2.26%, as its price correspondingly rose.

The major culprit for the poor performance: Revenue growth for U.S. firms remains disappointing, even as earnings are beating expectations (albeit diminished expectations). Elsewhere, other developed markets are faring better. Although European equities also suffered through a tough week, they at least have the cushion of stronger earnings, partly fueled by the euro's weakness. And in Japan, equities remain resilient thanks in part to a continued re-allocation into stocks by Japanese pension funds. All of these trends reinforce our preference for international developed markets.

U.S. Sales Falling Short

U.S. earnings season has gotten off to an uneven start. With a few exceptions—Amazon and General Motors stand out—last week was marred by several high-profile misses. Although most companies have beat on earnings, a surprising number are falling short on sales. Those with soft numbers included IBM, Verizon, Yahoo, United Technologies and even Apple. Perhaps more troubling: In many instances, a strong dollar was cited as a contributing factor; unfortunately, this may prove a problem in the third quarter as well.

The greenback touched a three-month high early last week before falling back later. The early gains were partly fueled by investors' reaction to stronger U.S. housing data, evidence that the U.S. housing market continues to firm. Sales of existing homes rose 3.2% in June, the fastest pace since 2007. Prices are also rising, with the median sales price up more than 6% year-over-year.

The easing of risks overseas and improvements in the U.S. economy have more investors convinced that the Federal Reserve (Fed) will begin lifting interest rates later this year, perhaps as early as September. While long-term yields fell on the week as investors turned to bonds amid the equity selloff, shorter-term yields were more resilient. Earlier in the week, two-year Treasury yields rose above 0.70%, flattening the yield curve in the process.

At the same time, expectations for higher U.S. rates pushed the dollar up, consequently hurting gold prices. Last week, gold prices traded to their lowest level in more than five years. Overall, commodities in general have been weakening—crude oil entered a bear market last week—as global growth and Chinese demand slip. Precious metals have come under additional pressure with the specter of the first Fed tightening in nearly a decade. Gold prices are responding, consistent with historical patterns, to the rise in real interest rates.

Revenue growth for U.S. firms remains disappointing, even as earnings are beating expectations (albeit diminished expectations). Elsewhere, other developed markets are faring better.

Positive Catalysts Overseas

Equities sold off globally last week, but Europe is at least having a good earnings season, while Japanese equities continue to benefit from institutional buying. In Europe, with Greece fading as a concern at least temporarily, investors are renewing their focus on earnings. Thus far, roughly 55% of European companies have beat estimates, with average year-over-year earnings-per-share growth of 15%. Banks and consumer discretionary companies have done particularly well, with 75% exceeding expectations.

In Japan, equities proved more resilient to last week's selling, even with an appreciation in the yen. One factor that continues to support Japanese stocks is the continued rotation into domestic equities by Japanese pension funds. The three largest public sector pension plans have already increased their equity allocation by over 5% since last spring. However, their allocations remain well below the 25% target, which suggests there is room for further institutional buying in the second half of 2015.

Catalysts like these—improving earnings in Europe and institutional stock-buying momentum in Japan—underscore why we believe European and Japanese equities can continue to outperform U.S. stocks.

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